Where I disagree and agree with Debraj Ray’s critique of Piketty’s Capital in the 21s Century.

Two people whose opinion I hold in very high esteem have told me, “Read Debraj Ray’s critique of Piketty; It is the best written yet.” I have read it before, but only in parts, and have focused on a few rather unimportant points in the first part of Debraj’s piece. So I decided now to read it carefully, and in full. It is a short piece, some 9 pages long. It is very well and clearly written. There are many things with which I agree.  But there are also many with which I do not. Let me start, because it is more fun, with the latter.

Debraj’s s key point is summarized in the last two sentence of his annex: “All I am saying is that it [any growth model] explains why r exceeds g. But the fact that r exceeds g explains  nothing about the rise in inequality.” At face value, it is a pretty damning critique of Piketty. First, r>g inequality is, as Debraj shows, a feature of any model of growth. It has nothing to do with being a “contradiction of capitalism.” Second, if inequality increases it is not because r is greater than g, as Piketty argues, but because capitalists have a higher marginal propensity to save. A bit earlier Debraj calls the much praised r>g inequality a “red herring.”

Let me now explain why I disagree with Debraj. While r>g (or r>=g) may be a feature of all growth models it is still a contradiction of capitalism for three reasons: because returns from capital are privately owned (appropriated), because they are more unequally distributed (meaning that the Gini coefficient  of income from capital is greater than the Gini coefficient of income from labor), and finally and most importantly because recipients of capital incomes are generally higher up in the income pyramid that recipients of labor income. The last two conditions, translated in the language of inequality mean that the concentration curve of income from capital lies below (further from the 45 degree line) the concentration curve of income from labor, and also below the Lorenz curve. Less technically, it means that capital incomes are more unequally distributed and are positively correlated with overall income. Even less technically, it means that if share of capital incomes in total increases, inequality will go up. And this happens precisely when r exceeds  g.

It is indeed a contradiction of capitalism because capitalism is not  a system where both the poor and the rich have the same shares of capital and labor income. Indeed if that were the case, inequality would still exist, but r>g would not imply its increase. A poor guy with original capital income of $100 and labor income of $100 would gain next year $5 additional dollars from capital and $3 from labor; the rich guy with $1000 in capital and $1000 in labor with gain additional $50 from capital and $30 from labor. Their overall income ratios will remain unchanged. But the real world is such that the poor guy in our case is faced by a capitalist who has $2000 of capital income and  nothing in labor and his income accordingly will grow by $100, thus widening the income gap between the two individuals.

So, if K/L ratios were the same along the entire income distribution, r>g would not have any special meaning. I grant that to Debraj. But precisely because the K/L ratio in capitalism is most emphatically not equal along income distribution (and we do not have a single historical example  where it was), but is rising, we do get increasing income inequality driven by r>g.

But, now, Debraj’s answer to that is to point out that this condition is not sufficient for rising inequality.  The requirement for inequality to go up is also that capitalists  should not spend most or all of their income, but rather invest it. Let us be clear: If capitalists were spendthrifts and used all their income on consumption,  there would be indeed no accumulation of capital, we would be in Marx’s simple reproduction, and Debraj would be right. But again this is not the  world we live in.  Not only is the assumption that capitalists save and reinvest 100% of their capital income a standard one in growth models (not because it is fully accurate but because it keeps the main features of the things in sharp relief; remember Marx’s “Accumulate, accumulate, it is Moses and all the prophets”). It also corresponds with empirical data. We indeed know that richer people tend to save greater proportion of their income (and people who receive more of their total income from capital tend to be richer). The other way to state that is to say that propensity to save out of capital income is greater than propensity to save out of labor name. This also tends to be empirically true.

Thus Piketty’s mechanism survives both of Debraj’s attacks. The standard growth requirement that r>g is indeed a contradiction of capitalism because in capitalism, capital owners are private persons and they tend to be rich.  And these rich people save more of their income, and gradually build up more and more of their capital stock, thus creating precisely the process of divergence of which Piketty speaks.

Now, why has Debraj gone astray in his otherwise very lucidly argued paper? Because he essentially assumes that economic processes described by theory of growth are abstract and do not take place in a capitalist environment where indeed the facts are such that capitalists tend to be rich (and not poor), and where such capital owners do not spend all of their income on consumption.

To conclude. If we had a capitalism  where capitalists were poor or a capitalism where capitalists would spend all of their capital incomes on booze and trinkets, yes, Debraj’s critique of Piketty would be right. But it just so happens that these are not the features of contemporary, nor of any other known, capitalism at least over the past 200 years.

This typically neoclassical and ahistorical approach to basically forget that the economic processes occur within a capitalist society, is also the reason why Debraj is wrong to wonder why Piketty calls a mere  identity, namely that the share of capital income in total income is equal to the rate of return  times capital/income ratio a fundamental law of capitalism. Seemingly reasonably, from his ahistorical point,  Debraj exclaims: this is just a definition of capital share in total output! It is an identity. How can it be a fundamental law?

Yes, it can. That definition carries weight in capitalism because it defines how much of total output  will be taken by a special class of population that does not have to work for its income. The more it gets, the less is left for those who have to work. It is not a Fundamental Law of Economics but it is a Fundamental Law of Capitalism.  (I made this point  in my review of Piketty’s book published on the Internet in October last year, forthcoming in the June issue of  the Journal of Economic Inequality). And to realize this, suppose that all capital is socially-owned and that income from capital is distributed equally among all population. Then clearly, capital share would be still the same as before, but this would not be a fundamental law nor a systemic problem since it would not imply unequal distribution of income, nor the existence of a class that does not need to work.

Debraj’s error consists, in my opinion, in not realizing that normal capitalist relations of production (where capitalists tend to be rich) are forgotten when we look at economic laws in an abstract manner. Not doing that is precisely a great virtue of Piketty’s book. Surely, (a) if capital/labor proportions were the same across income distribution; (b) if, more extremely, capitalists were poor and workers rich; (c) if capital were state-owned, all of these contradictions would disappear. But none of (a)-(c) conditions holds in contemporary capitalism. So Piketty’s economic laws and contradictions of capitalism do exist.

Where do I agree wit Debraj? That Kuznets curve cannot be easily dismissed. I am currently working precisely on this idea, alluded to also by Debraj, that we are now witnessing the upswing of the second Kuznets curve since the Industrial revolution. Moreover I believe this is not only the second but perhaps fifth or sixth or tenth such curve in western economic history over the past 1000 years. This is my next project, and there I come very close to agreeing with Debraj.

Does this agreement on Kuznets then, by itself, imply that my defense of Piketty’s mechanism cannot be right or consistent? Not at all. Piketty isolated the key features of capitalist inequality trends when they are left to themselves: the forces of divergence (inequality) will win. But there are also other forces: capital destruction, wars, confiscatory taxation, hyperinflation, pressure of trade unions, high taxation of capital, rising importance of labor and higher wages, that at different times go the other way, and, in a Kuznets-like fashion, drive inequality down. So, I believe, Piketty has beautifully uncovered the forces of divergence, mentioned some of the forces of convergence, but did not lay to rest the ghost of Kuznets inverted U shaped curve.

Limits of neoclassical economics

When people criticize Piketty for elevating  a mere economic identity that shows that the share of capital income in total income  is x times y (not important for my argument) to a Fundamental Law of Capitalism they show their inability to go back to economics as a social science, or differently, to transcend neoclassical economics.

The share of capital income in total income is not only a reflection of the fact that people with a factor of production B have so much, and people with the factor of production A have the rest. It gives us a measure of the share of the total pie that owners of capital (who are the principal social group in capitalism) are able to claim for themselves without having to work. This is key. We are basically saying: 20% of people of  the richest people claim one-half of national output and they do so without having to work. If it were a question of changing the distribution in favor of factor A (donuts) and against factor B (pecan pies), there would be no reason to be concerned. But here you change the distribution in favor of those who do not need to work, and against those that do. You thereby affect the entire social structure of society. This is where social science comes in, and neoclassical economics goes away.

The entire 100 years  of neoclassical economics was, in part, driven by the attempts to make us forget this key distinction: between having or not having to work for a living. Hence neoclassicists like to treat capital (and labor) as basically  the same thing: factors of production: a donut and a pecan pie. You have a bit more of a donut, I have a bit more of the pecan pie. No big deal. Thence also the attempt to treat labor as human capital. We are all capitalists now: a guy who works at Walmart for less than the minimum wage is a capitalist since he is using his human capital; a broker who makes a million in a day is also a capitalist, he just works with a different type of capital.

The true social reality was thus entirely hidden. But once you bring back the sharp dividing line between those work to earn and those who earn by doing practically nothing, you are back into a social science and you ask yourself questions like, would a society where 20% of non-workers earn 70% of total income be okay? What are the values that such a society would promote?  What would be the consumption patterns it would encourage? What is the  religion or ethical system that says that it is fine that people who do not work should be rich?  (Can we find one?) And what about equality of opportunity as such wealth would be transmitted to their kids.

The principal, and stark, issue then becomes: can a society where most of the rich are non-workers be called a  “good society"?

Why the FT comment on Piketty's weighting does not make sense.

Actually, I think weighting does not work. If you want to get the top 1% share for Europe (or any combination of countries), you cannot just weight the top shares; you would have to put the two or more datasets together, rerank all individuals or families by their per capita or per family wealth (use exchange rates to convert the wealth), and then get the share. Obviously, you cannot do that with the data Piketty has, so the only way is to do something is unweghted averaging.

Shares behave like Ginis; they are not convex measures. If you have a rich country with Gini=0, and a poor county with a Gini=0, when you put them together you do not get Gini=0, but a positive Gini. Think of the shares the following way. Let everybody in country A be wealthier than in country B and the two of the same population size. Then the information about top 1% share of wealth in country B is really worthless: these guys will not make it into top 1% share when you put the two countries together. You cannot weigh their top share by anything meaningful to get the result. In other words, does the top 1% share in Tanzania have any impact on the global top 1% share, if the richest 1% of people in Tanzania are at the global median? Obviously not.

My view of FT critique of Piketty

[This was originally posted on May 23, 2014 on a different Website and is being reposted here]

I think the FT case is blown out of proportion. It is well-known that wealth data are uncertain. I for one do not know where Piketty's wealth data come from and  I am sure very few people do.  There is also a myriad choices you have to make re. wealth estimations (e.g. capitalization or not; forward-looking or backward-looking) which you do not have to do when you use income.

(Although there are there, that is re. income too, many issues and many choices. If one were to go through my data, point by point, he could also detect a number of problems or inconsistencies: treatment of zero and negative incomes, imputation for housing, imputation of home consumption, what prices do you use for home consumption, how to get correct self-employment income etc etc. And many of these decisions vary from survey to survey and are not well documented, or the documentation is so immense that you cannot go through it or figure it out.)

The situation with wealth data --that much I know-- is much  worse. I was a referee twice for Davies  et al. global wealth inequality papers: there were many assumptions used in their papers, and there are even many more things you have no idea about, e.g. how is wealth defined in India, who is covered or not, how reliable it is, what prices are used etc. You just have to accept the numbers they (Indian statistical office or Davies et al) come up with. People may not realize that behind one such summary number there are 1000s of household-level data or even hundreds of thousands  and no one can go through hundreds of surveys and 1000s of individual data to verify them all.

And if you create (as Piketty did) bunch of data for a bunch of countries, there are bound to be issues. The question is, was there intentional data manipulation to get the answer one desires. I do not know it but it strikes me as unlikely that if one wanted to do it, he would have posted all the data, complete with formulas, on the Internet. And Thomas's data are not there since the book was published but were there for months or even years.

Now. consider FT points one by one:

"One apparent example of straightforward transcription error in Prof Piketty’s spreadsheet is the Swedish entry for 1920. The economist appears to have incorrectly copied the data from the 1908 line in the original source."

Okay, quite likely. When you transcribe hundreds of data, transcribing some wrongly is very likely. They give only one example. Are there more?

"A second class (sic!) of problems relates to unexplained alterations of the original source data. Prof Piketty adjusts his own French data on wealth inequality at death to obtain inequality among the living. However, he used a larger adjustment scale for 1910 than for all the other years, without explaining why."

Piketty has to explain why he used a a different adjustment scale. Let's wait to hear from him.

"In the UK data, instead of using his source for the wealth of the top 10 per cent population during the 19th century, Prof Piketty inexplicably adds 26 percentage points to the wealth share of the top 1 per cent for 1870 and 28 percentage points for 1810."

Same thing.

"A third problem is that when averaging different countries to estimate wealth in Europe, Prof Piketty gives the same weight to Sweden as to France and the UK – even though it only has one-seventh of the population."

This is neither here nor there. Perhaps the weights should be country wealth shares, not population shares. At times, you want to have unweighted averages and at times population- or income- or wealth-weighted. The question is whether one or another averaging makes more sense for the issue at hand and whether you stick to whatever you have chosen.

"There are also inconsistencies with the years chosen for comparison. For Sweden, the academic uses data from 2004 to represent those from 2000, even though the source data itself includes an estimate for 2000."

I do not understand this well. I have sometimes used (say) a 2003 survey to stand for the benchmark year 2000, sometimes for the benchmark year 2005. It just depends for what countries you have what data and also when. My data for (say) benchmark year 2011 improve as time goes by and I get more countries and more recent surveys.  So if you compare my global inequality estimate for a given year in the first draft of the paper and in the final version, they would often differ a bit.

In conclusion, the only real issue is why Piketty adjusted the data for several years differently, whether it is explained in the files, whether that explanation is reasonable, and if it is not explained, whether he can provide one. Out of the three "classes" of issues raised by FT, only the second has some validity. So far.